Yikes! Inflation Expectations Turned Negative Yesterday

In the wake of the FOMC’s decision Wednesday to ignore reality (and its own forecasts), the stock market dove yesterday. Inflation expectations, as approximated by the breakeven TIPS spread, also dove. And for the first time since March 2009, when the S&P 500 fell below 700, the implied breakeven TIPS spread on a one-year Treasury turned negative. I point this out just to illustrate the gravity of the current situation, not because there is a huge difference between the expectation of slightly positive inflation and slightly negative deflation.

Chairman Bernanke has been reduced to defending the indefensible. Paul Krugman properly castigated the FOMC’s abdication of responsibility this week. Scott Sumner believes that Bernanke’s heart is in the right place, but his hands are tied, and is therefore unable to do what he knows in his heart ought to be done. If Scott is right, then Bernanke has only one honorable course of action: to resign and to explain that he cannot continue to serve as Fed Chairman, presiding over, and complicit in, a policy that he knows is mistaken and leading us to disaster.

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“Might I point out first of all that the one year sector of the TIP curve from which this rate is calculated is hardly the most liquid or heavily traded (since most investors, when they think about protection from inflation, are looking to the distant future, rather than to a horizon that can be more easily forecasted). We have only two bonds of this maturity – the 0.625 TIIs of April 2013, and the 1.875s of 7/13; and in general one should note that the yields on particular securities are always subject to distortion by questions of idiosyncratic supply and demand, such that only two securities of approximately this maturity will not give us a good picture of the general state of expectations.

This being noted, the key point is that 1 year inflation expectations and implied breakeven rates are heavily influenced by commodity prices given their innate volatility, and not just their direct impact on the CPI (via gasoline, and food), but also their indirect influence via influencing producer costs in ways that may be directly reflected in the CPI.

If, as I understand he thinks, it was wrong for central panics to panic over the influence of commodity prices on the CPI as we approached summer 2008, then it is wrong to panic now about the mechanical impact of falling energy prices on CPI over the next year.

What we have is to a large extent good deflation resulting from a calming of turmoil in the Middle East, the diminishing prospect of an Israeli strike on Iran, a switch from crude oil to highly abundant domestically-produced natural gas and the still-neglected prospect of a massive increase in supply of crude oil from shale oil – in the US, and elsewhere. Serious people are now openly discussing the possibility of North America (ie including Canada) becoming self-sufficient in energy production, something that should certainly change the geopolitical map, in ultimately a positive direction.

We have also a shift in the commodity intensity of growth in China – there are only so many empty cities you can build, as well as a slowdown. This may well presage some adversity ahead for commodity producers (I wrote a year ago about the likely challenges that Latin America would face as commodity prices sold off), but for commodity consumers, the commonsensical view is correct, rather than that of the sophisters and economists – in other words cheaper gasoline is a good thing, and will continue to boost real consumer incomes and confidence.”

I wish I understood what is really on in Ben Bernanke’s mind and especially how the FOMC and Fed Board actually work. It’s easy for me to believe that Bernanke’s hands are effectively tied because of political intimidation from Congressional wingnuts who’d like to make the Fed more sensitive to political pressure via arbitrary congressional audits, or even abolish it altogether. Another, perhaps more plausible reason would be a perceived need to limit the scope of the Fed’s actions to things that no one on the board strongly objects to. (This is a apparently a common mode of bureaucratic decision-making within DoD.)

David,
The one-year TIPS expectations make sense given the recent steep decline in commodities prices.

Clearly, TIPS inflation is now a function of commodities price inflation, which is in turn a function of market QE expectations. This only underscores that commodity prices end up being the key transmission mechanism for policy. How could it be otherwise? Private service sector wages are not a very efficient monetary policy target, and government wages even less so.

Monetary policy is caught in a corridor between a service sector terms of trade shock and outright deflation. We are currently careening south through the lower bound, as your post suggests. When the Fed acts again (which it will), we will careen north of the upper bound. We’ve been in this corridor essentially since the spring of 2008.

In the past you’ve suggested the Fed target wages. How would it do so without facing this terms of trade dilemma?

David, it is even worse that that. 5y/5y inflation expectations is now close to zero. Hence, the market is basically seeing zero inflation from 2017 and five years ahead. Hence, the market is now basically pricing a Japanese scenario for the US economy. Who will remind Ben Bernanke about showing a some Rooseveltian Resolve…http://marketmonetarist.com/2011/11/01/needed-rooseveltian-resolve/?

Lars, that market may be pricing in a Japanese scenario but other markets (ie stocks) are clearly not. The question then becomes which market does the Fed follow/trust? I’m not a big fan of using the stock market to imply much about NGDP, but Bernanke has explicitly mentioned it as an indicator and I’ve seen some monetarists do so as well. In my opinion, Bernanke’s decision to discuss stocks now adds to the hand tying unless he’s willing to openly reverse that view.

The current trouble is that different markets are clearly showing different expectations for inflation/NGDP. Stocks are not pricing in a Japanese situation or deflation at the moment. Which market(s) should the Fed rely on? I’m not in favor of choosing stocks, but Bernanke explicitly discussed them as an indicator (market monetarists have too).

Cantillon Blog, I accept your cautions about the high noise to signal ratio in shorter-term TIPS. In my empirical work I have used the 10-year breakeven TIPS spread and that seems to provide the best fit in empirical models of the relationship between inflation expectations and stock prices, largely for the reasons that you mention. Admittedly, my reference to inflation expectations turning negative was slightly alarmist, but in the wake of what I regard as another irresponsible decision by the Fed to provide needed monetary stimulus, I believe that a bit of alarmism is called for. Having said that, I also concede to you that, insofar as the recent reduction in oil prices is the result of a positive supply shock rather than expectations of falling economic activity, the need for monetary stimulus may, indeed, be less acute than it was a few months ago. Nonetheless, I believe the weight of the evidence is still strongly on the side of additional monetary stimulus. We shall see how things turn out.

Bob, I’m afraid that I don’t have any particular insight into how the FOMC makes decisions, I just regard their stated reasons for the actions that they have taken as woefully inadequate and a discredit to Bernanke’s reputation as an economist.

David, I agree that short-run TIPS are sensitive to the most volatile elements of the CPI and that may be creating some tricky feedback effects. I think that stabilizing nominal wages would allow the terms of trade effects to operate without implicating monetary policy which would be a good thing.

Tubulus, Agreed.

Lars, I saw that 5-year inflation expectations dropped, but I didn’t see them drop very far below 2 percent.

Woj and Bubbles and Busts, I think that stock prices are still way under where they would be if the economy were operating close to potential.

Becky, You may be right, but my vocabulary is not as rich as I would like it to be.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.